01/30/2018

The Securities and Exchange Commission, in its long history, has never allowed companies to sell shares in initial public offerings while also letting them ban investors from seeking big financial damages through class-action lawsuits. That's because the agency has considered the right to sue a crucial shareholder protection against fraud and other securities violations.

But as President Donald Trump's pro-business agenda sweeps through Washington, the SEC is laying the groundwork for a possible policy shift, said three people familiar with the matter. The agency, according to two of the people, has privately signaled that it's open to at least considering whether companies should be able to force investors to settle disputes through arbitration, an often closed-door process that can limit the bad publicity and high legal costs triggered by litigation.

One can already hear the howls from the plaintiff's bar and their allies in certain institutional investor sectors, but this is an idea whose time has come.

The current system of securities class‐action litigation is an inefficient means to redress the harm to investors. Prominent studies have concluded that securities class‐action litigation fails to compensate adequately those harmed by fraud. The median ratio of settlement amount to total alleged investor loss has ranged between two and three percent. Securities classaction lawsuits are essentially wealth transfers among shareholders and often are circular in nature. Existing shareholders bear the burden of compensating aggrieved shareholders, some of whom also may be existing shareholders.

Although individual class members receive relatively little of the ultimate recovery that is spread across a class, the plaintiffs’ attorneys receive customarily twenty to twenty‐five percent of the total recovery. During the past ten years, plaintiffs’ lawyers, along with other middlemen, have obtained nearly $17 billion in fees from securities class actions. The diffused investors in the class lack the ability to bargain over attorney fees and courts rarely reduce the fees proposed by the plaintiffs’ attorneys.

In class‐action litigation, the interests of the plaintiffs’ attorneys and class members may not be aligned in some instances. The plaintiffs’ attorneys bear the full costs of pursuing the litigation but receive only a portion of the ultimate award. Consequently, the decisions of the plaintiffs’ attorneys may be driven by concern over litigation costs and personal gain rather than by an interest in obtaining the best result for class members. Indeed, the recent scandals involving plaintiffs’ attorneys paying large sums to repeat plaintiffs illustrate how class‐action litigation can be abused at the expense of harmed investors.

Companies and their shareholders incur enormous costs to defend against securities class‐action lawsuits. In one recent study, approximately forty‐one percent of the companies listed on the major stock exchanges had been named as defendants in at least one federal securities class action. The total monetary value of securities class‐action settlements in 2008 was $3.09 billion. The average settlement value from 2002 to 2008 was $45.6 million, which represents approximately a 175% increase from the average value of $16.6 million from 1996 to 2001.

Private securities litigation has become a real concern, particularly for new businesses that do not have the resources to handle a large lawsuit. A major lawsuit could sound the death knell for new companies that already bear a disproportionate amount of the total business tort costs in the United States. Although small companies account for nineteen percent of business revenue in the United States, they bear sixty‐nine percent ($98 billion) of the business tort costs. To cope with the cost of securities litigation, companies must raise the prices of their goods and services. Doing so, in turn, logically harms the competitiveness of U.S. businesses in a global marketplace that is dominated by low‐cost goods and services in the nations where providers do not face such threats.

Securities class actions impose a competitive disadvantage on U.S. capital markets relative to markets in other countries. Indeed, foreign companies are reluctant to list in U.S. markets due to concerns with the American litigation system. According to the Committee on Capital Markets Regulation - an independent, bipartisan body composed of twenty‐two corporate and financial leaders from business, finance, law, accounting, and academia - since the late 1990s the percentage of the world’s Initial Public Offerings (IPOs) conducted in the United States has dropped from forty‐eight percent to six percent in 2005. Of the world’s twenty‐five largest IPOs in 2005, only one of them took place in the United States. That trend continued in 2006, when a report dated November 30 observed that, in the year to date, nine of the ten largest IPOs had occurred in markets outside of the United States. Dollar figures are also staggering: Between 2000 and 2005, the percentage of dollars raised in global IPOs in the United States decreased by a factor of ten, dropping from fifty percent to five percent.

Where is the IPO activity going? The Committee report states that over the same time, London’s share of the global IPO market nearly quintupled from five percent to almost twenty‐five percent. United States exchanges attracted only about one‐third of the share of the global IPO volume in 2006 that they had in 2001 and only three of the twenty largest IPOs of 2008 were listed on U.S. stock exchanges. In 2009, the United States regained the global lead in amount of funds raised in IPOs, boasting a robust twenty‐seven percent share of global capital raised. But this number may be of little comfort when one considers that the share is mostly attributed to the $19.6 billion Visa IPO - the largest IPO in U.S. capital market history. Looking beyond this single outlier, it is apparent that capital formation has moved overseas in droves.

An unwieldy class‐action regime impacts not only the market for public offerings, but also the market for private offerings. The success of the venture capital industry relies, in large part, on how readily a start‐up or other privately held company can be taken public. Absent a desire to access the public equity markets in the United States, the amount of private equity activity in the United States also suffers. In contrast to federal litigation, securities arbitration appears to provide a more efficient and cost‐effective mechanism to resolve disputes with integrity while minimizing the burdens on our judicial system. Arbitration ensures that all relevant facts are presented to the panel without the evidentiary hurdles of federal court. In addition, the use of arbitrators knowledgeable about the securities industry may reduce the uncertainty of resolving securities claims in jury trials.

Bondi, Bradley J., Facilitating Economic Recovery and Sustainable Growth through Reform of the Securities Class-Action System: Exploring Arbitration as an Alternative to Litigation (2010). Harvard Journal of Law and Public Policy, Vol. 33, pp. 607-638, 2010. Available at SSRN: https://ssrn.com/abstract=1601305